Feature: February 21, 1996

February 21, 1996: Feature

The $4 Billion Question
Dodging A Bullet

The $4 Billion Question
Princeton's Endowment Boasts a Superb Record of Growth.
Now Its Managers Are Trying Aggressive New Investment Strategies.
Will They Pay Off?
By Allan T. Demaree '58

Richard B. Fisher '57, in shirtsleeves behind the round oak table in his 40th-floor Manhattan office, draws on his Montecristo Robusto cigar and tackles the question just put to him. Fisher is chairman of Morgan Stanley Group, among America's leading investment banks, and of Princo, the university arm that invests Princeton's endowment, which at $4 billion is the fourth largest in the nation. The question is whether he and the other alumni who have managed Princeton's money over the years have done their job well. Have they created wealth for Princeton?
Fisher knows that the welfare of future generations of Princetonians depends on the answer. Princeton's endowment provides a greater share of the university's budget than either Harvard's or Yale's (30 percent versus 21 percent and 15 percent, respectively). Preserving its spending power requires earnings to cover contributions to the university's expenses plus an allowance for inflation. Fisher is well aware that other endowments, including famous ones, have fallen painfully short of this goal. When he headed the finance committee of the Carnegie Corporation of New York in the 1980s, he found that the real value of Andrew Carnegie's original $125 million grant had declined since it was given in 1911.
How about Princeton's record? Fisher can't say for sure, since the university has never published figures that show the endowment's long-term performance net of inflation and contributions to the operating budget. This article reports those figures for the first time. They were assembled by Raymond J. Clark, Princeton's treasurer, and cover the last 19 fiscal years, for which reliable numbers are available. The results (top graph, page 19) are striking.
The endowment earned a compound average annual return of 14.2 percent over the period, versus 13.6 percent for the Standard & Poor's 500 Stock Index. A gift of $100,000 at the end of 1976 would have produced $216,000 of spending over the years and still be worth $627,000 today. When that figure is adjusted for inflation (using the higher-education price index, which has risen faster than consumer prices in general), the value comes to $217,000 in 1976 dollars-more than double the original gift. In addition, Princeton's endowment has outstripped both Yale's and Harvard's in long-term investment performance (bottom graph, page 19).
The most recent news, however, is less sunny. For the latest fiscal year, which ended June 30, Princeton trailed the S&P 500, which was sailing into the stratosphere, by 9.4 percentage points. John C. Beck '53, Princo's chairman before Fisher, says all investors get egg on their faces once in a while: "God grew us with platforms on which to put eggs. It comes with the territory." In any case, even while performing below par, Princeton's portfolio returned 16.6 percent for the year, well above the stock market's long-term average. Andrew Golden, who became Princo's president and top full-time professional last year, says that if this is as bad as things can get, "Hurt me, hurt me!"
Although it's nowhere designated as an official target, Fisher has set his sights on increasing the endowment's value, after spending and inflation in the university's costs, by an average of 2 percent annually. That might not seem a lot, but given the endowment's size, it would add some $80 million a year. In 10 years, through the glories of compounding, that would start to run into real money. Like $875 million. Indeed, Fisher says, if that can be achieved "we will have accomplished something extraordinary."
Princeton's strategies are aggressive and controversial. Fisher admits to-indeed, he takes pride in-being a contrarian investor. Example: By investing in New York City real estate when others shunned it a few years ago, Morgan Stanley paid $176 million for a new headquarters building that cost some $435 million to construct. Since assuming the Princo chairmanship in 1990, Fisher has rearranged Princeton's portfolio like a croupier sliding chips across a craps table's green felt. Where the chips have landed may not comfort the risk-averse. Hedge funds, emerging market equities, leveraged buyouts, depressed real estate-all these are amply represented in Princeton's portfolio.
Some critics think the policies are risky or ill-conceived. The 14-member Princo board, made up mainly of trustees and alumni with financial experience, has debated their wisdom, and doubts persist, as they must when the outcome is inherently unknowable. But the quality of intellectual combat, and the dedication of the combatants to achieving the best they can for Princeton, has been worthy of the institution. To watch the process unfold is to see some of America's better-informed financial minds wrestle with perplexities that all investors must confront in facing the uncertain markets of tomorrow.
Fisher is the fourth alumnus since the late 1920s to lead Princeton's investment strategy, and he is hardly the lone contrarian. The legendary Dean Mathey '12 presciently moved out of stocks before the Great Crash of 1929 and back into them in time to catch the post-World War II bull market. Harvey Molé '29 (what a graduating class for an investor!) was a growth-stock maven who, most famously, lent Ray Kroc $1 million to buy a California hamburger chain called McDonald's, making Princeton's investment back many times over on an "equity kicker" tied to the number of hamburgers sold. John Beck succeeded Molé in 1977 as chairman of what was then known as the trustee investment committee.
While Mathey and Molé called their own shots, Beck, a lanky investment counselor who heads the New York firm of Beck, Mack & Oliver, began parceling out the endowment to a handful of money managers and allowing them full discretion over the securities they chose. The university's internal staff was lean: "Harvard had 160 people, we had Carl Schafer," he says, referring to the university's financial vice-president at the time. In 1987, the endowment having grown robustly during Beck's tenure, the university created Princo (officially, the Princeton University Investment Company) to deal with the complexities of size and the increased diversity of investment options. Princeton's endowment is now just a scosh behind Yale's. On June 30, the latest date for comparable figures, Yale had $3.98 billion versus Princeton's $3.88 billion. The oil-rich University of Texas System ranked second, with $5 billion, and Harvard first, with $7 billion. As of December 31, Princeton's endowment stood slightly above $4 billion.
When Fisher took over from Beck he immediately began rethinking Princeton's strategy. "This is a perfect opportunity to look at everything," he said. "Let's go back to zero and assume we own nothing." Beck, who remains on Princo's board and chairs the trustees' finance committee, to which Princo reports, says the reassessment began on Day One of the Fisher regime, exactly as it should. "I did what I wanted to do," Beck says of his years at the helm. "A democratic process it was not, nor should it be." Though the two men differ widely in investment style, Beck and Fisher seem to harbor no professional jealousies. "No two individuals will ever manage money in the same way," says Beck, "and those who defer to their predecessors are probably destined to have real problems."
Fisher's reassessment did not alter the fundamental goal. As Beck puts it: "The school is the soul of the institution, and we are the wallet that provides for the soul. We are just as avid in the pursuit of the almighty dollar in legitimate ways as they are at Goldman, Sachs." Beyond that, however, Fisher proposed sweeping changes. They began with three operating tenets, all of which were arguable, though the first might not seem so to anyone unschooled in financial theory.
Tenet No. 1 was that the portfolio could benefit from "active management"-that is, from the same kind of research-intensive selection of stocks and bonds performed by most professionals who invest on behalf of clients. While that may appear self-evident to the casual investor, and while Princeton has always followed that practice for the endowment, it is not the gospel taught on campus by Burton G. Malkiel *64, the Chemical Bank Chairman's Professor of Economics.
Malkiel, who was on the Princo board when he taught at Yale in the 1980s, is a known sympathizer with the so-called efficient market hypothesis, having popularized the concept in his book A Random Walk Down Wall Street, published in 1973. While the hypothesis takes several forms-"weak," "semistrong," and "strong"-and its validity and application are still fiercely debated, it generally leads to the conclusion that even the smartest investors can't beat the stock market over the long term. This is because, in major markets like the U.S., investors search assiduously for information about companies and act on it rapidly, bidding up the prices of shares they expect will have high returns and driving down those they expect to do badly. Through this process, everything known about a company's prospects is likely to be reflected in its stock price. The market is therefore said to be efficient, and prices change only with news-random information that cannot be known in advance (hence "random walk").
If that is the case, chimpanzees with a dart board have as good a shot at beating the market as do security analysts. The notion that stock-picking is a fool's game tends to be buttressed by the fact that, after management fees are deducted, most mutual funds perform worse than the market averages. So rather than spend time and money hiring investment managers, Princeton might better buy an "index fund," which invests in a broad basket of shares designed to mimic a market index like the S&P 500. (Indexing is called "passive" as opposed to "active" management.) President Shapiro has expressed skepticism about the efficacy of active management. An economist by training-though never one who specialized in stock prices, he says, "much to my mother's dismay"-he asks a simple question when he talks with Fisher and other Princo directors: "Explain to me why you're any smarter than anybody else and why we can't just invest in an index and go home and live and die by the index and just not worry." He begins these discussions thinking they can't convince him. So far they have.
After Malkiel returned to Princeton, he left the Princo board. Shapiro was eager that someone with a similar perspective replace him so that the directors would continue to debate the issue. That man was John C. "Jack" Bogle '51, who built Vanguard Group, the second-largest mutual fund company (after Fidelity) and the biggest purveyor of index funds. Bogle made sure the Princo board stayed on its toes, says Fisher. "Jack's been extremely valuable. He keeps apologizing to me for being annoying, and I keep saying, 'Jack, for God's sake, the last thing we want is for everyone to agree.' You know you're in trouble if everyone agrees." So far, the evidence supports those who believe Princeton can beat the market. The managers who invest in U.S. equities have outperformed the S&P 500 for the past three, five, and 10 years.
The second tenet Fisher put forth has proved dead wrong-so far. He thought that double-digit investment returns would be much harder to achieve in the nineties than they were in the high-flying eighties. The corollary was that Princeton would have to indulge in new (some say esoteric) strategies like hedging and derivatives to keep returns bubbling. As it happened, however, "plain vanilla" securities, good old U.S. stocks and bonds, did just fine over this decade's first six years. In their miscalculation Fisher and friends had plenty of company. The Yale and Harvard portfolios have underperformed the domestic stock and bond markets lately for the same reason Princeton's has. Much of their money is invested overseas or in other areas that have missed the spectacular performance of U.S. equities. The recent fireworks in American stocks simply strengthen Fisher's conviction that the rest of the nineties will have as much zip as week-old porridge. "I'd be willing to bet that the U.S. stock market for the next five years will underperform long-term returns," he says. Whether that's sagacity or stubbornness talking is impossible to know.
Fisher's third tenet was that Princeton should put more money into "alternative assets," which include venture capital, real estate, oil and gas wells, and other relatively risky and illiquid investments. When Fisher came in, Princeton had only a small percentage of its money in this category. He and the board have set a target of 25 percent. That's a large wager. It will require Princeton to invest $250 million to $300 million annually in alternative assets over the next several years.
Alternative assets scare people, not without reason. John Train, a New York investment manager and columnist for The Financial Times of London, told The New York Times last summer that "this brings back disagreeable memories of 1972-73, when university money managers were seized by a rapture that led them into excess risk, and they were punished horribly in '74." Because alternative assets are illiquid and subject to hits and misses, the endowment managers can't be sure of their worth at any given moment, and values may fluctuate wildly. Randall A. Hack '69, who manages these assets for Princeton, notes that "a speculative start-up company could return 30 percent or be a dry hole." And Fisher points out that the economic cycle in real estate "is much more vicious from top to bottom than triple-A bonds or high-grade equities."
But risk walks hand in hand with reward, says economic theory. Hack believes alternative assets can achieve returns five percentage points higher than marketable securities-"and ideally something close to double that." If he could produce the five-point spread for a quarter of today's portfolio, in 10 years Princeton would be richer by more than $625 million. Widen the spread to 10 percentage points and you're looking at an incremental gain of nearly $1.6 billion. While alternative assets are risky, diversifying-putting eggs in many baskets-can reduce the risk of the overall portfolio. "Frankly," Fisher says, "I'm glad that there are people who think alternative assets are too risky because it keeps money out. I wish we were the only endowment doing it."
What sayeth Professor Malkiel? "A very smart move." Why? Two reasons. First, the values can be better in alternative assets than in marketable securities, precisely because the factors that make public markets efficient and hard to beat-rapid, widespread communication of information-don't work as well in private markets. This means people like Hack who invest brain power and shoe leather can seize opportunities others haven't found. Second, history shows that after a run of hot years, as we have had in the eighties and nineties, equity markets "tend to revert to the mean." For U.S. stocks during this century, the mean has been about 10 percent, and Malkiel joins Fisher in thinking that returns for the rest of the nineties will be below those of the last 15 years.
Having put his propositions on the table, Fisher needed someone to work through tough policy questions and execute the strategy. Princo was still thinly staffed in 1990-Beck never required many bodies to accomplish his ends-and Princo's first president, T. Dennis Sullivan '70, was leaving to become financial vice-president of the Mellon Foundation. Headhunters were set to work, corporate-style, to find a replacement, but the man who got the job, Randy Hack, emerged not from their exertions but from the old-boy network. Hack's stepfather-in-law is Robert H. B. Baldwin '42, who like Fisher once headed Morgan Stanley. Beck knew Hack for years and regularly played paddle tennis with his brother-in-law as a doubles partner. When Hack saw Beck in September 1990, he had sold his New Jersey real-estate business (at the top of the market), taken a couple of years off, and was looking to go back to work at something deeply satisfying.
Beck knew Hack's blood ran orange-and-black. Twenty-three members of Hack's and his wife's families have attended Princeton, beginning with his grandfather, who came from farming and brewing stock in Vincennes, Indiana, and took the train east in 1899 to enroll in the university, sight unseen. Beck says, "It dawned on me we could really use a pair of legs like Randy's." He suggested Hack apply for the Princo job. Hack replied that he wasn't qualified. Yes, he had an MBA from Harvard and had done well in real estate, but he was an entrepreneur, a dealmaker, not an expert in stocks and bonds. Beck answered that Princo didn't need an investment specialist. It needed a strategist and company builder who could create the kind of organization Fisher envisioned to achieve his objectives.
Hack's background was, Fisher says, "a little off-beat," but Hack proved to have all the qualities of an investor that Fisher looks for-"he's smart, hardworking, skeptical"-and Fisher thinks hiring him was "one of the best things I ever did." Beck elaborates: "You know Randy is bright when you first meet him. If you live with him any length of time, you become fully persuaded that he's part of the solution. He brought us a set of arms and legs and ears and eyes without which I don't think Dick Fisher could have functioned. Not only is Randy energetic and productive, but he and Dick related very well, so Dick was able to operate a more complicated structure than I could. Randy is a prodigious worker. His wife could kill me for hiring him at Princeton. He never came home. He has a great love for Princeton and felt a great debt to the university and this was his way of effectively working it off. We hired him for three years minimum, which was more or less his military service for Princeton."
Tall and rangy, with long fingers that dance to the torrent of his words, Hack tore into his new career. Issue by issue he researched the critical questions facing the endowment, summing up his analysis in multi-appendixed reports that were high on smarts and low on jargon (he was an English major). What is the ideal mix of assets for Princeton's portfolio? How can Princo get maximum return for minimum risk? What can a "Monte Carlo simulation" tell about whether the portfolio will meet the university's spending needs while sustaining the endowment's purchasing power? Hack found the exercise "a fascinating learning experience."
Over the next four years the portfolio changed radically. Foreign securities recently accounted for 16 percent of total assets. In Beck's day they were one-third that amount. Beck had no money in hedge funds, which bet on the relative performance of different companies by buying, say, Wal-Mart and selling Kmart shares short. Now hedge funds make up some 14 percent of the portfolio. Alternative assets zoomed from a paltry amount to 16 percent. At this point, Hack figured, it was time for him to return to the entrepreneurial world that was his first love. He would build an organization to focus exclusively on alternative assets for Princeton, picking the best funds in the field and, for the first time, making a full-bore effort to invest directly in private companies, real estate, and other ventures.
The trustees agreed to the establishment of Nassau Capital, which Hack founded in January 1995 with three partners. Together they put up, he says, a "meaningful seven-figure number" of their own money-he won't be more specific-to invest side-by-side with Princeton. Nassau Capital gets a fee, plus a sliding-scale percentage of profits tied to performance. Some trustees thought Nassau Capital's prospects so bright that they wanted to invest their own money, but Fisher and other trustees believed it inappropriate for volunteers to have a financial interest in a venture they oversaw.
The new company nestles cozily in a Georgian brick building at 22 Chambers Street, a few blocks from Nassau Hall. The offices are just across an elevator bank from Princo and up a flight from Scottish Widows Investment Management, Ltd. Hack's move left a vacancy at Princo, which was filled by Andrew Golden, 36, who used to manage money for Yale. So now, at the operating level, it's the Randy 'n' Andy Show, with Hack concentrating on alternative assets while Golden runs the much larger part of the portfolio invested in marketable securities.
Being a newly adopted, rather than natural, son of Old Nassau seems not to have dimmed Golden's ardor for the place. He arrived in early 1995. Curly haired and bespectacled, with a pleasantly academic air, Golden grew up in South River, New Jersey, which used to be 20 minutes from Princeton and, he says, "thanks to progress" is now 40 minutes away. He majored in philosophy at Duke, starved while trying to make it as an artist, studied finance at Yale's School of Management, and worked for the Eli analog of Princo. There, he grew enamored of investing, particularly on behalf of an endowment with dedicated alumni overseers who believed in pursuing aggressive investment strategies.
When Princeton called, Golden was back at Duke, where he anticipated a long career investing for his undergraduate school. But the chance to manage a big pool of capital supporting a major institution with a mission "in the Nation's Service," he says, made the offer irresistible. In an odd way, he adds, lacking a Princeton degree heightened his affinity for the university. "It's kind of like the difference between love for parents and love for spouse. I made a conscious decision to get married to Princeton."
Golden talks unabashedly about the Princeton "family" that has taken him in. The word may seem out of context in the bottom-line world of investing. Yet Beck uses it, too, in describing the university's time-tested strategy for building the endowment: place your confidence in a few well-chosen alumni and give them responsibility without micro-managing them from above. "Within our family," he says, "there are always such individuals. Dick Fisher is a classic example of somebody who should never have given the time he has to this, and yet he does it with great willingness and ability." At Morgan Stanley, Fisher earns some $4 million a year; Princo gets his services for free. The other board members (who are also uncompensated) gather around Fisher "to provoke him," Beck says, not to make decisions by committee. "I've long since learned that there are many ways of succeeding in our business. Key to me is that there be one person whose thoughts guide the process." The worst thing, he adds, is "flopping around."
Beck also believes a tight-knit group can act quickly in moments of urgency. In 1987, for instance, the investment committee fired two of its 11 external managers and had converted their portfolios to $260 million in cash when, on October 19, the stock market went into its famous 508-point swoon. At eight o'clock the next morning and again that afternoon, as the financial world quivered, Beck got on the phone with Fisher and a few other committee members, and they decided to stare down the face of fear. They bought $125 million in S&P 500 index-futures contracts and made $15 million as the market recovered.
Happy as that result was, the events hurt feelings and highlighted sensitivities inherent in managing the endowment. One of the fired managers was an alumnus, Herbert E. Gernert '48, who had been investing in equities for Princeton for nearly a decade. From the beginning, he says, the investment committee told him he could raise or lower his commitment to stocks, depending on his view of the risks in the market. Thinking that share prices looked frighteningly high, he began cutting back on stocks in mid-1986, which hurt his performance as the market kept galloping ahead. At a meeting in August 1987, he told the investment committee he wanted to reduce his equity holdings from 70 percent to 60 percent of the portfolio, but by then the committee didn't want him to have that flexibility. "It got to be a session of disagreement," he says.
That September, Beck dismissed him, and Gernert still smarts. He feels he got canned for doing the right thing, the committee was lucky in accumulating cash for the wrong reasons, "and then they went around and blew their horn about how conservative they were just before the crash." Others close to the situation say it was more complicated. Independent of Gernert's firing, the committee was raising cash because the market was high, and some members were uncomfortable because Gernert was starting to pass responsibility for Princeton's account to an associate at his firm they didn't know. Beck declines to comment.
This contretemps aside, Fisher says that selecting the right money managers is another key to investment performance. Unlike Mathey and Molé, Fisher picks no stocks. The world has grown too complex for that. Besides, portfolio theory holds that most of the return to investors comes not from picking particular stocks or timing the market but from choosing the right asset categories-U.S. equities, emerging market debt, and so on. So Fisher and his colleagues decide on broad strategies, and Princo hires the best external managers it can find to execute them.
How can you pick sharp managers? Fisher says by weighing past performance and understanding how a manager operates. (Has he been lucky or smart?) Princo, which now uses 15 managers for marketable securities, has fired firms, even if they were producing excellent returns, if it didn't like the way they produced them. A hedge fund hired for its global stock-picking ability, for example, was dismissed after it started making heavily leveraged bets on European interest rates and commodities like zinc and silver. Otherwise, Princo doesn't second-guess managers in the short run, preferring to gauge results over a couple of market cycles. It holds their feet to the fire by measuring their performance against yardsticks-the S&P 500 for equity managers, for instance, or the Consumer Price Index plus 7 percent for hedge funds.
So far, the record on manager selection is encouraging. Over the last three years, managers in four of the five categories measured-equities, hedge funds, fixed-income securities, and alternative assets-outperformed their bogeys. The lone laggards? So-called global-balanced managers. Adopted four years ago, global-balanced management is an experiment of the kind Princo tries in search of higher returns. In the standard relationship, Princo would hire a manager to invest in a specific category-say, emerging-market equities-and he would have no option but to stick with that category, even when he considered it overvalued. Global-balanced managers are freed from that constraint and may move money wherever they find the best returns. Unfortunately, the three global-balanced managers Princo hired guessed wrong. They put too little into U.S. equities, and currency movements turned against them. Because they managed 22 percent of the endowment, that stung. Princo is reassessing the strategy.
Princeton's money managers think the university has several advantages over other investors. One is the endowment's size. If the portfolio were as big as some corporate pension funds, which run to $55 billion for General Motors, the endowment's managers would have to find huge investments with outsize returns in order to materially improve overall results. Deals like that are tough to come by. On the other hand, if the endowment were the size of, say, Transylvania University's $67 million, Princeton couldn't afford to mount the effort required to find exciting ideas or invest in enough of them to diversify the risk. Happily, Princeton falls between the extremes-big enough to underwrite the quest for ideas, small enough that investing in those ideas will make a difference. Think of it as the Goldilocks factor-not too big, not too small, but just right.
Another advantage is financial strength. Because Princeton can afford to ride out the market's ups and downs without worrying about having to sell at the bottom, it can invest in volatile and illiquid assets with the potential for high profits. These advantages combine to make alternative assets a natural choice. As Hack says, "We can play in that vast, deep, broad, relatively inefficient middle market of private opportunities." If an investment of $10 million in a start-up company hits pay dirt, it can boost the endowment's performance significantly.
Alternative assets can increase returns in ways ordinary stocks and bonds can't. Hack distinguishes between "value recognition" and "value creation." When Princeton's managers buy a publicly traded stock, they hope they will be early to recognize value-savvy management, hot technology-and that others will wake up to that value later and be willing to pay more for the stock than Princeton paid. Nassau Capital, by contrast, seeks to create value by influencing the management of the companies in which it invests. Once you buy a publicly traded stock, you have one decision every morning-hold it or sell it. But when you own a major stake in a private company, you can try all sorts of things to strengthen the operation. That creates value, and almost by definition, should create profit. During Nassau Capital's first year, Hack invested $60 million in eight companies, and he wants to make direct investments an increasing share of the portfolio. Crucial to accomplishing that goal is working what he calls the Princeton network, which includes alumni, professors, other investors Princeton deals with, and executives in the companies it invests in. Well represented across industries and widely dispersed geographically, alumni may come across promising opportunities or be able to help assess potential deals that have popped up on Nassau Capital's radar screen. "Someone always knows more than you could know about a particular company, topic, management team," says Hack. "If I can get to that person, I'm 10 steps ahead of other private-equity firms that don't have that affiliation. I believe the Princeton network is more powerful than the Internet."
From the double-barreled approach of investing both in funds and directly in companies, Nassau Capital bags double-barreled insights. As a direct investor, Hack says, "You really see the dirty underwear of the fund world. You see who the leaders are, who the blowhards are, who are the big talkers but don't show up at the board meetings of the companies they own. We've already identified some firms that a year ago we thought were pretty good and today we wouldn't touch." On the flip side, by investing in funds, Nassau Capital gets a window on the ideas in the fund managers' minds and the companies in their portfolios.
That's how Nassau Capital came to buy into the confections division of Kraft Foods, the biggest marshmallow producer in North America. Kraft wanted to sell the business. A fund in which Princeton had invested, run by Texas Pacific Group, was leading the transaction and looking for additional equity to round out the deal. Nassau Capital's participation in the fund would have given it a $780,000 stake in the company, but after researching the business, Hack decided to invest $12.5 million more in it directly.
What made this deal so sweet? As a stepchild of Kraft's cheese business, the confections division was burdened by overhead and starved for management attention. "Believe it or not," says Hack, "marshmallow-extrusion technology allows you to produce a lot of fascinating products that Kraft never bothered to get around to." You can coat marshmallows with chocolate, fill them with candy-indeed, come up with all manner of innovations that could destroy teeth and set nutrition back decades. Come Easter, watch for the company, now known as Favorite Brands International, to bring out marshmallows shaped like little rabbits. They're called BunnyMallows. "Sounds simple, right?" says Hack. "Sounds kind of ludicrous. Well, last year in a test market they flew off the shelf." Nassau Capital has taken a seat on the board of directors, which is helping the management find add-on businesses in related specialties like snacks and nuts. This gets to his theme of creating value. "Nassau Capital is set up to add value itself, or align itself with people who can, beyond simply giving somebody money," he says. "If we can't do that we don't deserve to exist." In time, the plan is to take Favorite Brands public or sell it to a large food company for a tasty profit.
Hack looks for industries in the throes of structural change and markets that are hard to understand-ventures that would confound less intrepid investors. "If it's simple, everybody is going to be in it," he says. A skein running through a few deals is the restructuring of the $800 billion-a-year health care business and the opportunities created for entrepreneurs who can improve efficiency and cut waste. Hack sank $3 million into Americaid, Inc., which is building HMO networks in New Jersey, Illinois, and Texas for people on Medicaid. On Medicaid? Does that sound like a not-for-profit undertaking? Well, many states trying to bring costs under control have licensed HMOs as an alternative to Medicaid-as-usual, so revenue is practically guaranteed. The question is whether Americaid can improve cost-effectiveness to reduce the burden on taxpayers and make a profit. As Hack says of alternative assets generally, "There is a huge execution risk." The return on his part of the portfolio last year-19.6 percent-seemed worth the risk. Nassau Capital benefited from a strong market in initial public offerings, which allowed the funds in which Princeton invested to sell off companies at high prices. Whether the strategy will pay off long-term will take years to know.
Management of the endowment raises some thorny questions. One obvious one: Is Princeton too cozy with its alumni? A handful of graduates guide the investment process. Randy Hack both participates in it and profits from it. And, increasingly, Hack plans to call on the Princeton network to generate deals. Beck points out that some institutions recoil from doing business with alumni. The chief financial officer of a West Coast university told him it wouldn't invest in a company run by an alumnus because of the potential for conflict of interest. Beck thinks this ridiculous. "We like our alumni. We will get that extra measure from our alumni. We think we'll get a better deal, dealing with people who are of the family. That's been the spirit through the years."
What may raise eyebrows is the lack of public disclosure. Although Hack acknowledges that the compensation arrangement between Princo and Nassau Capital gives him "enormous incentives" to make money for Princeton, the details are secret. Neither does Princo reveal the identity of its money managers and their performance, which leaves room for doubt about whether they hold their jobs by merit or connections.
The kind of misunderstanding that can arise from this situation was illustrated by an article in The Wall Street Journal last fall, which reported that Morgan Stanley got "the mandate to manage Princeton University's huge endowment, thanks in part to Mr. Fisher's role as chairman of the Princeton endowment fund." The implication of self-dealing was unmistakable. It was also false, and the Journal retracted the statement. Fisher had in fact removed his firm from consideration in managing endowment money under ordinary circumstances. The only exception came when Princo was looking for a specialist in emerging-market equities. The field of potential managers was small and the directors felt Morgan Stanley was a clear leader, so they asked Fisher to recuse himself and hired the firm. The account constitutes 1.4 percent of the portfolio.
People at Princo defend their disclosure policies on several grounds. "If alumni investment manager X finds out we have hired his rival Y, that's better kept confidential," says Golden. Fisher says revealing individual performance statistics would militate against managers' maintaining a long-term focus. "We'd get 500 phone calls of, 'Why don't you fire this manager, he didn't perform last year?' This is not productive. It won't improve the process." As for Nassau Capital, Fisher believes that having Hack's money at risk with Princeton's and his compensation tied to profits will contribute to the venture's success, but he sees no benefit in disclosing details. The arrangements are favorable to the university, he says, and have been approved by the trustees, who are charged with protecting Princeton's welfare. If outsiders question the propriety of the deal, well, Fisher says, "The dogs bark, but the caravan moves on."
A second question is whether the university reports as clearly as it should on the endowment's overall performance. Until it produced the numbers for this article, it had not disclosed or, indeed, calculated for its own use long-term investment returns minus spending and inflation. Yet this is the touchstone for determining whether the fruits of past generations' generosity are being preserved for future generations' benefit. Fisher points out that other institutions don't report this figure either, and that people generally want to know how Princeton stacked up against other universities and the market averages. Princeton often cites these comparisons in its financial reports, and both have merit. Unfortunately, they also have shortcomings.
In gauging its performance against the market, Princeton compares itself with a "benchmark" portfolio of 65 percent U.S. equities (the Standard & Poor's 500 stock index) and 35 percent U.S. bonds (the Lehman Brothers Government/Corporate Bond Index). The endowment has done well against that standard, beating the benchmark 12 out of the last 19 years. But the bogey is something of a straw man. Golden thinks of it as the "default position" of a typical institution. It entails lower risks and is expected to produce lower returns than Princeton's more aggressive portfolio. Fisher acknowledges that Princeton should beat it over the long run (even though the university fell short last year).
When Princeton compares itself with other institutions, it uses the universe of endowments reporting to the National Association of College and University Business Officers. The goal is to place in the top quartile, and in fact Princeton ranked in the 96th percentile over the last 10 years for which numbers are available. But, again, the bar is lower than it appears. Of the 461 endowments reporting, 99 percent are smaller than Princeton's, and, as one might expect, performance generally improves with size, sophistication, and the effort an institution can mount managing its money. Perhaps one can't blame the university for gauging itself against these yardsticks. Who wants to fight Mike Tyson when Peter McNeeley is available? But everyone concerned with Princeton's well-being would get a truer picture if the university publicized returns minus spending and inflation-the genuine bottom line.
Finally, does the endowment spend enough on Princeton? After the Yale game last fall, the Whiffenpoofs and Nassoons gathered on stage in Alexander Hall, their voices raised on high. Nassoon baritone Reilly Coch '97 stepped forward and announced, "The next song is brought to you by Gordon Wu," the Hong Kong entrepreneur and member of the Class of 1958, who had just pledged $100 million toward the university's Anniversary Campaign. The song's title was "Princeton Is Free." Sample lyric, sung to a laid-back calypso tune:
No need to pay the thirty grand
When you've got fiscal sleight of hand.
No need for dollar
When you're a scholar.
Princeton is free.
It was a side-splitter. It also raised a perennial issue about the trade-off between endowment spending and growth.
Rob Hordon '96 put the matter provocatively in a letter to The Daily Princetonian. After citing the endowment's size and the rising cost of a Princeton education, which next year will come to $28,325 in total fees, he suggested that "a little re-distribution is in order." As Hordon put it: "Sure it's a nice feeling to know that we have a little something tucked away for a rainy day, but with four billion, we have enough tucked away for the Apocalypse. Wouldn't it be nice if at least a portion of that money were used to make tuition costs a little less absurd? . . . Will the pride a student feels when the endowment hits the five billion mark compensate for the fact that grandma can't afford that operation or that mom and dad can't pay the mortgage and are now living in a van by the river?"
A week later, Jeff Siegel '98, one of four students on the Priorities Committee, which recommends the annual budget to President Shapiro, answered Hordon, arguing that prudent management of the endowment is precisely what has supported educational excellence while keeping tuition from climbing even higher. Whatever is tapped from the capital pool today is siphoned away from tomorrow's students. Shapiro is nothing if not sensitized to the issue of "generational equity." The question is, how much will the endowment earn in the future? Guarantee Shapiro that the next 15 years will produce returns as high as the last 15 and he would gladly devote more of the endowment's income to holding down tuition.
But is the immediate past the future? History suggests not. Look, for example, at investment returns for the two 15-year periods that preceded the last one. From 1950 to 1965 the returns were fat, followed by lean years from 1965 to 1980, when, after inflation, investors actually lost money. Hard times could return.
Every year, usually in October, Shapiro sits down with Princo's directors and goes around the room asking each the same question: What do you expect the average rate of return to be for the next 15 or 20 years?
"The interesting thing," he says, "is that since I became president eight years ago, virtually without exception, everybody's estimate has come down," from 11 percent to 10 !/2 to 10. At the last meeting, he recalls, most pegged growth at 9 percent or slightly less. Shapiro cites some cautionary figures: Princeton's costs have been rising about 6 percent a year, and the university usually spends 4 !/3 to 4 !/2 percent of its endowment's value annually; these numbers total a fraction above 10 percent. So if the endowment earns 9 percent, the result will be a shortfall. The university continues to examine its policy on spending the endowment, including the option of spending less of it-"precisely the opposite of what some people propose," says Shapiro. "So there's no disagreement on the fundamentals. It's a question of what the expected rate of return is. I'm not an expert in these matters, but we have an impressive board at Princo. These are experienced, knowledgeable people, so we try to live by what they advise us."

Allan T. Demaree '58, a former executive editor of Fortune magazine, lives in Scarsdale, New York.

Dodging A Bullet
The scandal of 1995 in the mini-world of endowment investing happened at the Common Fund, a nonprofit group in Westport, Connecticut, that manages some $19 billion for about 1,400 colleges and other educational institutions. A trader at a firm employed by the Common Fund took unauthorized risks and lost $138 million in endowment money. For three years Princeton did business with the same firm, First Capital Strategists-but jettisoned it long before the loss occurred. Princeton had discovered what the Common Fund learned too late: First Capital lacked proper internal controls.
When John C. Beck '53 chaired the trustee investment committee in 1983, he hired First Capital to handle securities lending for the university. Securities lending often takes place when an investor wants to "sell short" a stock he doesn't own. For him to do so, his broker must borrow the shares from someone else. He then sells the borrowed shares, hoping that the price will fall and he can buy them back at a profit. First Capital lent Princeton's securities to shortsellers for a fee and used the cash collateral that borrowers put up to make money on index arbitrage.
First Capital was raking in a tidy profit for Princeton when warning lights flashed. Beck had a list of brokerage houses to which the firm was allowed to lend securities, along with limits on the exposure Princeton was willing to accept for each. To track compliance, Princeton set up a computer program in the treasurer's office. On several occasions, the computer hiccuped: First Capital had violated the guidelines. Calls to the firm determined that its partners didn't know they were out of compliance. They promised it wouldn't happen again. Within weeks it did. Beck fired First Capital in 1986. No money was lost.
After last year's $138 million loss, the Common Fund sued First Capital, charging that its controls were again at fault. The suit alleges that the errant trader, Kent Ahrens, violated guidelines governing a "low risk" index-arbitrage strategy. Index arbitrage squeezes a profit out of small disparities between the values of index futures and a basket of stocks they represent. Ahrens was supposed to fully hedge himself against market risk by offsetting long positions in stocks with short positions in futures, or vice versa. But Ahrens, whose compensation was tied to his arbitrage profits, gambled that he could make more money by leaving himself unhedged and betting on the market's direction.
Early in 1992, the suit says, the market turned against him. He lost $250,000 in one day. Then he tried to trade his way out of trouble. As Cambridge Associates, a consultant, reported to the Common Fund's member schools: "His attempts to trade himself out of a small hole resulted in his digging an everdeeper pit." Ahrens kept his trading records on his personal computer, and no one at First Capital or the Common Fund had access to them. The suit says losses mounted for three years before Ahrens, who has said nothing publicly, confessed to his superiors.
-Allan T. Demaree '58